Settlement agreement determines fine's or penalty's deductibility.

IRS Letter Ruling (TAM) 200502041 held that a portion of a lump-sum payment made to settle claims arising under the False Claims Act (FCA) was a nondeductible fine or similar penalty within the meaning of Sec. 162 (f). The Service's analysis in reaching this conclusion reaffirms the importance of (1) including language in a settlement agreement as to the tax characterization of the payment and (2) providing supporting documentation.

Facts

In the TAM, the taxpayer owned and operated numerous businesses that performed a wide range of tests for the U.S. government. Based on suspicions of unauthorized and inappropriate billing, the government began investigating the taxpayer under the FCA. The parties began settlement discussions to determine the government's estimated actual damages; they also discussed trebling actual damages under the FCA.

They eventually entered into a settlement agreement under which the taxpayer agreed to pay a lump sum in exchange for the government's release of all present and future liability for the conduct underlying the investigation. However, the agreement was silent as to (1) the purpose or tax characterization of the payment and (2) the portion (if any) that represented treble damages.

The taxpayer deducted the settlement payment under Sec. 162(a) as an ordinary and necessary business expense. The IRS took the position that a portion of the settlement payment represented punitive treble damages and, thus, was a nondeductible fine or similar penalty under Sec. 162(t:).

IRS's Analysis

Sec. 162(f) disallows a deduction for any "fine or similar penalty paid to a government for the violation of any law." Regs. Sec. 1.162-21(b) defines "a fine or other similar penalty" to include "any amount ... paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal)"; it also states that compensatory damages do not constitute a fine or similar penalty. It is well established that the purpose behind a fine or penalty must be analyzed to determine whether it is punitive or compensatory in nature. Punitive fines and similar penalties fall under Sec. 162(f); compensatory damages are deductible under Sec. 162(a).

Look to settlement agreement: TAM 200502041 cited Middle Atlantic Distributors, 72 TC 1136 (1979), in stating that a settlement agreement's language is the most important factor in determining a lump-sum payment's purpose. However, the settlement agreement at issue was silent on this point. Thus, the Service looked to Talley Industries, Inc., 116 F3d 382 (9th Cir. 1997), in which the Ninth Circuit stated that the burden is on the taxpayer to demonstrate "entitlement to a particular deduction."

Purpose of treble damages: The Talley court also determined that the FCA's treble-damages provision served both punitive and compensatory purposes. While this portion of a settlement may be compensatory (because it is intended to "make sure that the Government would be made completely whole"), it is also intended to maximize the FCA's deterrent effect. The Ninth Circuit remanded Talley back to the Tax Court to determine whether the treble damages were intended to compensate the government for its losses or to punish the taxpayer. On remand, the Tax Court (TC Memo 1999-200) concluded that the parties disagreed as to the trebled amount's purpose. Because the taxpayer was unable to demonstrate that this amount was meant to be compensatory, the Tax Court ruled it nondeductible under Sec. 162(f).

Facts and circumstances: In the TAM, because the settlement agreement was silent as to the payment's intended purpose, the IRS looked to the facts and circumstances surrounding the parties' settlement negotiations; specifically, it examined "the best evidence available to determine the proper allocation of this lump-sum settlement payment." Looking at correspondence between the parties and the government's internal documents, it ruled that the government's purpose in claiming treble damages was to punish the taxpayer. The taxpayer was unable to provide any documentation to support its contention that such amount was meant to be compensatory. Thus, the portion of the settlement amount that represented treble damages was nondeductible; the nontrebled portion, which represented compensation to the government for its actual losses, was deductible.

Observations

The TAM'S conclusion reaffirms the importance of including appropriate language in any settlement agreement and providing documentation to support the payment's characterization for tax purposes. The IRS recognizes that language contained in a settlement agreement can be controlling as to characterization. However, if a settlement agreement is silent, the Service may assume that any payment is punitive in nature, unless the taxpayer can demonstrate otherwise. Accordingly, it is crucial for taxpayers to include clear language that provides the purpose for making the settlement payment. Additionally, they should document all meaningful discussions between the parties, to support the tax position as to deductibility of the settlement amount.

FROM KRISTIN HAHN, MS, CHICAGO, IL